Small business owners are tasked with making both simple and complex business decisions almost on a daily basis. The success or failure of a business lies primarily in how decisions are made and what steps are either taken or ignored. One of the most crucial aspects of any business is bookkeeping. Hate it or love it, you must play the bookkeeping game whichever way you understand it.
One of the many bookkeeping decisions you’ll have to make as a small business owner is deciding between cash or accrual accounting. Intentionally or otherwise, you’ve used one or both types of accounting and probably never understood the significance.
Before explaining these accounting terminologies, let’s begin with the basics of running your business. You pay vendors to supply you with products, and your customers pay you to take those products from you. This is the cycle of business. At the end of each cycle, you make a profit and repeat the process.
The difference between cash and accrual accounting is how and when such transactions are recorded in your books.
What is Cash Accounting?
In its simplest form, cash accounting makes a record of a transaction only when there’s an exchange of cash. If this sounds too familiar, then it’s probably the type of accounting you’ve been practising.
For a more practical explanation, let’s imagine Mr. A buys a product from you today and pays for it immediately. Would you record it as today’s sales? The answer is probably yes!
Again, same scenario but this time, Mr. A buys the product today and promises to pay on the 15th of next month. Would you still record it as today’s sales or wait to record it when he pays on the 15th of next month? You’re practising cash accounting if you wait to record it when he truly pays the cash on the promised date.
What is Accrual Accounting?
Accrual accounting makes a record of all transactions regardless of whether cash was paid or not. It is the opposite of cash accounting.
Following the same example above, Mr. A buys a product worth $100 on the 15th of July and promises to pay on the 15th of August. Accrual accounting says the transaction would be recorded on the day the transaction occurred, which is on the 15th of July.
For many new small business owners, this may seem a bit absurd. Why record a transaction that hasn’t been paid for in the books? However, accrual accounting has its advantages and adheres to the Financial Reporting Standards (FRSs).
Advantages of Cash Accounting
Cash accounting is popular among many small businesses because of its advantages. These include:
Ease of Use
Cash accounting is pretty straightforward to operate. Anyone with a pen and a book can easily perform this bookkeeping system. When cash is received, a record is made. There’s no need to keep track of unpaid promises – cash is king!
Cash Flow Projections
Cash flow is an important part of business accounting. Since cash accounting records only cash payments, it is easy to make financial projections with the available cash in hand.
Since financial records are only updated when cash changes hands, only declared cash income is liable to be taxed. When your tax is calculated using your financial records, all income is accounted for since the total cash recorded was actually received.
Disadvantages of Cash Accounting
Cash accounting has its drawbacks. It is why it is not suitable for large-scale businesses.
A major drawback is that it can be misleading and inaccurate. When you make a purchase from a vendor without paying cash, your business remains in debt for the period. Not recording the expense when it was incurred doesn’t absolve the business from the debt.
This can also mess up the business inventory. Items sold without being paid for are no longer in the business inventory. Since they’re no longer available to sell, the business assets are lower than the books show.
Advantages of Accrual Accounting
Some of the advantages include:
Accurate Financial Reporting
Recording transactions when they occur, irrespective of whether cash was paid, gives a better picture of the true financial standing of the business. It’s easy to know the business’s profitability at any given time by just looking at the books. For example, a customer owing the business would show in Accounts Receivable as expected income, while goods to be paid for will reflect under Accounts Payable.
Realistic Planning and Projections
Since the records show the true financial position of a business, business owners can make better and more realistic projections. Restocking of inventory can be projected for when cash is received. Unnecessary or unimportant future purchases can be held off until outstanding debts are cleared.
Disadvantages of Accrual Accounting
The drawbacks of accrual accounting are why many small businesses prefer to use cash accounting. These include:
Higher Financial Literacy Required
Accrual accounting is not as straightforward as cash accounting. It takes time and patience to acquire the skills to use this system. Unfortunately, for many new and existing small businesses, this is a luxury they often cannot afford.
Cash Flow Uncertainties
As much as accrual accounting allows for realistic financial projections, this doesn’t take away the fact that projections are based on customers fulfilling their promises. This can affect the survival and future of the business if care is not taken.
By declaring all transactions, whether cash is received or not, a business is liable to pay taxes on the entire declared amount. Whether the declared income has been received in full or not, the business must still pay the total accrued tax.
What Accounting System is Best for Small Businesses?
Having gone through the advantages and drawbacks of each system, choosing the best accounting system would depend on several factors. Since businesses will each have their own unique financial experience, there’s no definitive choice on which system is generally best.
For a good way to know which system to stick with, the answers to these questions can as a guide for small business owners:
- Do you plan to sell the business in the future?
- Will the accounting books ever be audited by external auditors?
- Do you plan to apply for a bank loan in the future?
If a company hires external financial auditors to look into its financial records, they’re more inclined to trust an accrual accounting record than cash accounting. Cash accounting is only ideal for small businesses with little or no inventory and low to average sales revenue.
Making the right choice between cash and accrual accounting would depend on many factors. These would include the complexity of the business and the revenue generated by the business. Each system has its advantages and drawbacks and should be closely examined when making a decision.
If you manage the bookkeeping for your company on your own, you should go through these helpful bookkeeping tips for small companies to ensure your books are accurate and give the right picture. But if you think this is not your cup of tea, turn to the experts – Timcole, to manage it for you. Timcole offers customised bookkeeping packages that are curated for your business needs.